FINANCIAL STRUCTURE

OBJECTIVES

General Objective laysia. Specific Objectives

: To understand the structure of financial system in Ma

At the end of the unit you will be able to : explain the evolution, function, role and structure of the financial system in Malaysia which consist of banking system, non-bank financial intermediaries and financial market.

explain the role and function of financial institution and financial intermediar ies in the countrys development. tem. explain the assets, sources and uses of fund and steps taken to develop the sys explain in details about the flow of funds and the direction of credits. explain in details about the latest monetary policies.

explain the acts that regulate financial institution BAFIA 1989, the Offshore Ba nking Act 1990 and Islamic Banking Act 1983. explain the role and purpose of regulatory body in Malaysian financial system.

explain the characteristics, roles and objectives of International Offshore Fin ancial Centre (IOFC). discuss the factors that contribute to the successful operation of the Internati onal Offshore Financial Centres (IOFC). describe the financial services which is offered by International Offshore Finan cial Centre (IOFC). Discuss the incentives given to the participants who operate in Labuan. identify the challenges faced by the financial sector in the global economy.

1.0

EVOLUTION, ROLES AND STRUCTURE OF THE FINANCIAL SYSTEM

In this chapter, we will discuss about the Malaysian financial structure. Let us begin with the: EVOLUTION OF THE FINANCIAL SYSTEM The development of a sound and financial system is a necessary pre-condition for a stable and balanced economic and social development in Malaysia. In this rega rd, Bank Negara Malaysia (BNM) has consciously and systematically developed a mo dern and sophisticated financial system. The financial system has effectively mo bilized and allocated resources for productive use in tandem with the rapid tran sformation of the economy. The development can be divided into four phases: First phase. The first priority of BNM in the early 1960s was to create the basic infrastruct ure for the financial system. It is also to develop a truly Malaysian-oriented b anking system to complement the presence of strong foreign banking in the econom y. Therefore, early efforts were focused on institutional building in order to develop an extensive domestic banking network and re-orientate the operations fo reign banks branches to domestic needs. Second phase In the 1970s, BNMs efforts were focused on introducing other financial intermedia ries. The establishment of merchant banks, the first of which was set up in 1970 , satisfied the growing need for financial expertise in wholesale banking and co rporate financing. This is caused by the expansion of the public and private ent erprises which progressed towards more technology-oriented activities, involving more complicated forms of financing. In addition, BNM was also instrumental in establishing a number of development finance institutions and the Credit Guarant ee Corporation to ensure a better position for the financial system to serve the financing needs of a more diversified economy. Another significant development during the decade was the enactment of a new legislation, the Banking Act 1973, to strengthen the regulation and supervision of banking institutions. Third phase In the 1980s, BNMs efforts were focused on further strengthening the regulatory a nd supervisory framework for the banking system. The latter part of the 1980s wa s a period of prudential re-regulation and significant structural changes in the banking system. These changes were comprehensive and prompted by lessons from d omestic development as well as the global recession in the early 1980s. As a res ult, the Malaysian banking system was strengthened considerably, and was able t o remain sound and intact despite the severe consequences of the sharp recession following the Asian financial crisis.

Fourth phase The 1990s was characterized by rapid changes shaped by the forces of liberalizat ion and globalization, aided by technology which broke new frontiers in the func tioning of financial markets and in the development of financial products. The A sian crisis was a catharsis that catalyzed national and international efforts to strengthen domestic financial system and the financial architecture. These iss ues will remain on the Malaysian agenda in the years ahead, including an acceler ation of on-going efforts to consolidate the banking industry and to inject grea ter dynamism and competition into the system.

ROLES OF THE FINANCIAL SYSTEM Banking System The banking system consists of BNM, the banking institutions and other financial institutions, namely the discount houses, the representative offices of foreign banks and offshore banks in the International Offshore Financial Centre in Labu an (Labuan IOFC). BNM, as the central bank, is at the apex of the banking system, and is r esponsible for the regulation and supervision of the banking system, with the ex ception of the offshore banks operating in the Labuan IOFC which comes under pur view of the Labuan Offshore Financial Services Authority (LOFSA). The commercial banks are the main players in the banking system. They ar e the largest and most significant providers of funds in the banking system. The range of transaction accounts typically offered are savings account, current ac count, fixed deposits and negotiable instruments of deposits (NIDs). They provi de facilities for making payments or monetary transfers in domestic or foreign c urrencies, both locally and internationally; makes commercial and industrial loa ns and trade finance. Finance companies form the second largest group of deposit-taking instit utions in Malaysia. They provide finance (credit) , e.g. to operate hire purchas e transactions on behalf of retailers of consumer goods such as cars and electro nic and electrical equipment. Merchant banks filled the need for large corporations which require bulk y financing and complex banking services, by complementing the facilities offere d by commercial banks which are more focused on providing short-term credit for working capital and trade financing. They also play a role in the short-term mon ey market and capital raising activities. Discount houses specialized in short-term money market operations and mo bilize deposits from the financial institutions and corporations in the form of money at call, overnight money and short-term deposits. The funds mobilized are invested in The Malaysian Treasury bills (TB), Malaysian Government Securities (MGS), bankers acceptances (BA), negotiable instrument of deposit (NID) and Caga mas bonds. Non-bank financial intermediaries These institutions are generally under the supervision of various govern ment departments and agencies. All of them deal with funds. They mobilize funds from certain sources and channel them to the deficit units. Like their sources, the uses of these funds varies. Development finance institutions help to promote the development of cert ain economic sectors through long-term investment financing. On the other hand, provident and pension funds is designed to meet contingent financial needs of th eir clients and further assist the public sectors development efforts by subscrib ing to government securities. Finally, saving institutions are important to the small-time savers ant the rural population who usually have less opportunities t o utilize existing banking facilities.

Financial Market The financial market in Malaysia comprise the money and foreign exchange market, the capital markets, the derivatives markets and offshore markets. The money market is an avenue for the channeling of short-term funds wit h maturities typically not exceeding 12-month. It provides a ready source of fun ds for market participants facing temporary shortfalls in funding, while at the same time, providing short-term investment outlets for those with temporary surp lus funds. Unlike the money market, capital markets are markets for raising long-te rm funds containing the equity and bond markets. The derivatives markets are for trading instruments that provide conting ent claims on underlying assets, and whose values depend on the price of the und erlying assets or securities. The Labuan IOFC is aimed at enhancing the attractiveness of Malaysia as a regional financial centre, as well as to promote the economic development of L abuan and its vicinity. STRUCTURE OF THE FINANCIAL SYSTEM The structure of Malaysian Financial System is presented in Figure 1.1. FINANCIAL INSTITUTIONS FINANCIAL MARKETS Banking System Bank Negara Malaysia Banking Institutions Commercial Banks1 Finance Companies Merchant Banks Others Discount Houses Representative Offices of Foreign Banks Offshore Banks in Labuan IOFC

Non-Bank Financial Intermediaries Provident and Pension Funds Insurance Companies2 Development Finance Institutions Savings Institutions National Savings Bank Co-operative societies Other Non-Bank Financial Intermediaries Unit Trusts Pilgrims Fund Board Housing Credit Institutions Cagamas Berhad Credit Guarantee Corporation Leasing Companies Factoring Companies Venture Capital Companies Money & Foreign Exchange Markets Money Market Foreign Exchange Market Capital Market Equity Market Bond Market Public Debt Securities Private Debt Securities

Derivatives Market Commodity Futures KLSE CI Futures KLIBOR Futures Offshore Market Labuan International Offshore FinancialCentre (IOFC) 1Including Islamic banks 2Including Takaful Figure 1.1 Financial System ( Source: The Central Bank and the Financial System in Malaysia A Decade of Change; BNM 1999) 1.1 ROLES OF FINANCIAL INSTITUTIONS AND FINANCIAL INTERMEDIARIES IN THE DEVE LOPMENT OF COUNTRY. 1) Intermediation function The financial system, comprising both financial institutions and markets, acts a s an intermediary of resources in the economy. This intermediation function invo lves the mobilization of resources by providing the means for savers to hold mon etary and financial assets, and allocating these resources for productive invest ment. An efficient financial intermediation system helps channel resources effic iently towards activities with high rate of return, as well as allow implementat ion of projects that are larger in scale, and with longer gestation period and r iskier prospects. In addition, efficiency also means that information is process ed well, allowing investment opportunities to be identified so that resources ca n be channeled to these activities. 2) Operation of the payment system A payment system essentially refers to a network of services that facilitates tr ansactions involving the exchange a means of payment in return for goods, servic es, real assets and financial assets. The means of payment can take on many form s such as currency, cheques and credit cards, as well as modern electronics mean s such as stored-value cards. The instruments, institutions and services that fa cilitate the transfer of value to discharge the payment obligation, serve as the payment system architecture. Therefore the payment system is a central element in the economic infrastructure that facilitates the efficient clearing and settl ement process. Therefore, it has a significant effect on the operating efficienc y of an economy. As key players in the payment system, strong and efficient fina ncial institutions are essential for the efficient functioning of the payment sy stem.

3) As a channel for transmission of monetary policy In addition to its contribution to the development of the economy, a well-functi oning and efficient financial system is vital for the effective conduct of mone tary policy. This is because monetary policy is transmitted primarily through th e banking system. On the other hand, an inefficient banking system, usually char acterized by financially weak banking institutions and inefficient market mechan isms may render monetary policy less effectively in achieving its objectives. In an environment of emerging inflationary pressure, the ability of a central bank to raise interest rates would be constrained if the financial institutions are weak. This is because higher interest rates would weaken the health of the corpo rate sector and lead to the deterioration in the asset quality of the banking in

stitutions.

1.2

ASSETS, SOURCES AND USES OF FUND AND STEPS TAKEN TO DEVELOP THE SYSTEM.

ASSETS OF THE FINANCIAL SYSTEM Assets of the financial system are presented in Table 1.1.

Banking system1 Bank Negara Malaysia Banking Institutions Commercial banks2 Finance companies Merchant banks Discount Houses Non-bank Financial Intermediaries Provident and Pensions Funds Insurance funds Development Finance Institutions Saving Institutions Other Non-bank Financial Intermediaries Growth (% per annum) Outstanding (end-period) 1988 1997 (Avg.) 1998 1988 1998 (Avg.) RM billion As % of financial system 1987 1998 1987 1998 19.2 16.2

19.7 18.9 21.8 21.5 21.4 17.2 15.4 18.6 12.5 13.3 25.0 -5.6 14.5 -8.8 -5.4 -18.9 -11.4 -4.6 8.5 12.6 11.1 28.0 -4.2 -1.6 16.7 16.1 16.7 16.5 17.3 18.0 18.8 16.4 15.2 17.9 13.8 11.6 22.3 140.6 24.2 113.4 85.8 21.3 6.3 3.0 61.6 36.8 6.4 4.8 5.4 8.3 766.7 124.7 622.0 459.2 123.6 39.2

20.2 326.6 174.0 39.3 19.8 18.0 75.5 69.5 12.0 56.1 42.4 10.5 3.1 1.5 30.5 18.2 3.2 2.4 2.7 4.1 70.1 11.4 56.9 42.0 11.3 3.6 1.8 29.9 15.9 3.6 1.8 1.6 6.9 Total Assets

18.6

-1.8

16.6

202.2

1,093.3 100.0

100.0

1Excludes Offshore Banks in Labuan IOFC 2Includes Bank Islam Malaysia Berhad Table 1.1 Assets of the financial system (Source: The Central Bank and the Financial System in Malaysia A Decade of Change; BNM 1999)

SOURCES AND USES OF FUNDS Table 1.2 summarizes the structure of the sources and uses of funds of the finan cial system in selected years of the period.

Sources of funds: Capital, reserve & profit

Currency Demand deposits Other deposits1 (of which): Public sector Other financial institutions2 Private sector Foreign Borrowings Funds from other financial institutions Domestic2 Foreign Insurance, provident & pension funds Other liabilities 1988 1993 RM million 17,866 9,037 11,387 93,347 25,130 18,615 49,328 274 5,612 12,208 7,567 4,641 47,438 32,913 7.8 3.9 5.0 40.6 10.9 8.1 21.5 0.1 2.4 5.3 3.3 2.0 20.6 14.3 41,936 14,649 33,450 198,015 1998 %

RM million

RM million

28,351 38,868 127,237 3,558 5,768 56,403 27,014 29,389 99,653 119,460 7.4 2.6 5.9 34.8 5.0 6.8 22.3 0.6 1.0 9.9 4.7 5.2 17.5 21.0 102,445 20,547 65,111 457,954 40,393 103,870 305,699 7,993 14,400 66,074 39,600 26,474 189,791 176,998 9.4 1.9 6.0 41.9 3.7 9.5 28.0 0.7 1.3

6.0 3.6 2.4 17.4 16.2 Total liabilities 229,808 100.0 569,335 100.0 1,093,321 100.0

Uses of funds: Currency Deposits with other financial institutions Domestic Foreign Bills Treasury Commercial Loans & advances Public sector Other financial institutions Private sector Foreign Securities Malaysian government Foreign Corporate Others Gold & foreign exchange reserves Other assets 905 33,479 28,418 5,061 5,962 4,472 1,490 93,084 2,242 2,264 87,562 1,016 62,717 51,349 2 11,366 0 17,271

16,390 0.4 14.6 12.4 2.2 2.6 1.9 0.6 40.5 1.0 1.0 38.1 0.4 27.3 22.3 0.0 4.9 0.0 7.5 7.1 1,597 115,827 108,768 7,060 7,825 2,737 5,088 209,802 2,860 3,767 201,787 1,388 105,245 61,047 69 41,703 2,427 75,309 53,729 0.3 20.3 19.1 1.2 1.4 0.5

0.9 36.9 0.5 0.7 35.4 0.2 18.5 10.7 0.0 7.3 0.4 13.2 9.4 3,224 151,578 136,138 15,440 14,648 3,796 10,852 485,712 5,567 28,995 448,318 2,832 225,569 71,575 1,269 141,781 10,944 96,265 116,324 0.3 13.9 12.5 1.4 1.3 0.3 1.0 44.4 0.5 2.7 41.0 0.3 20.6

6.5 0.1 13.0 1.0 8.8 106 Total Assets 229,808 100.0 569,335 100.0 1,093,321 100.0

1Equal savings, fixed and other (NIF,LPHT, etc) deposits + NIDs + repos 2Effective 1998, the statutory reserves of the banking institutions have been re classified as Funds from other financial institutions rather than Other deposits from other fin ancial institutions. In this regard, data for prior years have also been revised accordingly. Table 1.2 Sources and uses of funds of the financial system (Source: The Central Bank and the Financial System in Malaysia A Decade of Change; BNM 1999) STEPS TAKEN TO DEVELOP THE SYSTEM The development of Malaysias financial system has evolved over several decades ag ainst the backdrop of rapid changes in the economy and the international financi al environment. This development has been significantly shaped by BNM, and the approach of BNM in this regard has been pragmatic and flexible. Consequently, po licies have been modified according to the changing circumstances, to achieve th e objective of financial sector development, that is, to develop an efficient an d sophisticated financial system that can support balanced economic development. The steps taken are as discussed below: 1. Leveling the playing field Several measures were introduced during the period of 1989-99 to level the playing field to allow commercial banks, finance companies and merchant banks t o compete on equal ground with each other. These include the adoption of a stand ard ratio for the statutory reserve requirement (SRR), as well as the introducti on of the risk-weighted asset approach as the uniform method of capital adequacy assessment for the three groups of banking institutions. The harmonization of s tandards was aimed at enhancing competition among the three groups of banking in stitutions, which were essentially engaged in the same type of business. 2. Interest rate reforms In line with the objective to develop a more market-driven financial syste m, the process of interest rate reforms resumed, following its abandonment durin g the period of tight liquidity from 1985-87.The pegged deposit rate arrangement was dismantled in 1987. Meanwhile, with effect from 1st February 1991, the bas e lending rate (BLR) of the banking institutions was completely freed from admin istrative control, with banking institutions allow to charge a maximum of 4 per centage points above their declared BLR. With the freeing of the BLR, both the d eposit and lending rates were expected to be determined competitively by the ban king institutions, taking market forces into consideration. There was, however, a long transmission lag for policy (approximately 2-3 months). To reduce this lag, a new BLR framework was introduced in November 1995 , whereby the BLR was linked to the weighted monthly average of the 3-month BNM interbank rate. In 1998, the BLR was linked to the 3-month BNM intervention rate instead of the 3-month interbank rate. This has reduced the transmission lag to

within one week. In addition, the maximum margin over the quoted BLR was also r educed from 4 percentage points to 2.5 percentage points. 3. Institutional development - International Offshore Financial Centre (IOFC) was established on 1st Octob er 1990 in Labuan, in order to enhance the attractiveness of Malaysia as a regio nal financial centre, increase the contribution of the financial services sector to the nations GDP and promote the economic development of Labuan and its vicini ty. The IOFC conducts a variety of international banking, insurance and investme nt activities. - As part of the institutional building to develop the capital markets, BNM in itiated the establishment of the Securities Commission (SC) on 1 March 1993. A s eparate institution is necessary to consolidate the regulation and supervision o f the capital markets as well as oversee future measures to broaden and deepen t he markets. In addition, it is also recognized that there is a need to further d evelop the capital markets as an alternative source of funding primarily for the private sectors. - BNM also developed the private debt securities market and the Rating Agency Malaysia Berhad (RAM) to rate debt issues by corporations. - To further develop Kuala Lumpur as a key financial centre, the decade also s aw initiatives being taken to promote trading in options and financial futures. On 15th December 1995, with the launching of KLOFFEs stock index futures contrac t, Malaysia becomes the fourth Asian country after Singapore, Hong Kong and Japa n to offer domestic equity derivatives product. Another milestone during the dec ade was the commencement of trading on the Malaysian Exchange of Securities Deal ing & Automated Quotation Bhd. (MESDAQ), a stock exchange targeted specifically at growth and technology companies, on 30 April 1999. - In the banking system, the launching of the interest-free banking scheme in March 1993 provided the foundation for developing a viable and comprehensive Isl amic banking system. 4. Consolidation and restructuring of the financial system The consolidation of the banking institutions over the past decade, in essen ce, begin with efforts by BNM to restructure the banking system following the ba nking crisis in the mid-1980s. While the banking sector entered the financial cr isis in 1997 from a position of strength, the severity of the crisis weakened th e health of the banking sector, as reflected in the deterioration in capitalizat ion and asset quality. Following these developments and anticipation of further adverse implications of the crisis on the banking system, BNM adopted a pre-empt ive and comprehensive four-pronged plan to restructure the financial system. Thi s involved a strategy to consolidate the finance company industry, and establish ing Danaharta, Danamodal and Corporate Debt Restructuring Committee to deal with the emerging problems of deteriorating asset quality and capitalization, as wel l as corporate debts, respectively. Nonetheless, the crisis exposed the vulnerability of small banking institut ions and the need for these institutions to maintain a high level of capital. In this regard, it has always been on the agenda to encourage banking institutions to merge in order to achieve economies of scale and higher level of efficiency. This move is aimed at strengthening the capacity, capability and ability of dom estic banking institutions to meet the challenges arising from an increasingly c ompetitive global environment. 5. Payment system The design and development of effective and efficient payment systems have b een an integral part of BNMs initiative to further enhance the operations of the financial system. The forces of financial globalization and rapid technological

advancements have also provided the impetus for the promotion for payment mechan ism that are inexpensive, secure, reliable and efficient. Towards this, BNM launched the payment system masterplan in 1996 to chart the development and implementation of payment system in Malaysia. The masterplan was formulated along the lines of the four major modes of payment instruments, namely, cash, cheques, card-based payment instruments and electronic-based payme nt mechanism. 6. Prudential and regulatory reforms In Malaysia, the regulatory and supervisory framework of the banking system has been continually reviewed since the early 1980s in order to ensure that it r emains relevant in the light of structural changes in the domestic economy and external environment. This review led to the introduction of the Banking and Fin ancial Institution Act 1989 (BAFIA) in October 1989. BAFIA provides a framework for an integrated supervision of the Malaysian financial system and enhances the powers and duties of the auditors of licensed institutions and made a director, officer or controller of a licensed institution liable to indemnify the institu tion in full for any loss or damage in any form arising from or caused by on off ence committed by any person. Another major related development was the transfer of regulation and supervi sion of the insurance industry to BNM with effect from 1st May 1988. The main r ationale behind the relocation was to streamline and adopt an integrated approac h to the supervision of the entire financial system in the country and to realiz e economies of scale in regulation and supervision. On its part, BNM has also reviewed its supervisory approach by focusing on a reas of high risk that have adverse implications on the soundness of the banking institutions. In this regard, BNM has adopted risk-based supervision which emph asizes a combination of dynamic off-site surveillance and on-site examination. 7. Liberalization of the financial sector Malaysia recognizes that the opening up of the domestic financial sector to foreign competition would contribute towards a more efficient, competitive and m arket-driven financial sector, thus enabling the sector to play a more efficient and effective role in the economy. At the same time, it is recognized that for the benefits of liberalization to be fully realized, the pace of liberalization has to be in tandem with the capacity and ability of the system to absorb these changes without undermining financial stability. This policy has resulted in a high foreign participation in the Malaysian financial sector.

Activity 1A

TEST YOUR UNDERSTANDING BEFORE YOU CONTINUE WITH THE NEXT INPUT! 1.1 Describe briefly the structure of the financial system in Malaysia.

1.2 What are the roles of the financial institutions and financial intermediar ies in the development of a country? 1.3 List down three sources and uses of the financial system funds.

Feedback To Activity 1A

1.1

a) Financial institution i. Banking system ii. Non-bank financial intermediaries b) Financial markets i. Money and foreign exchange markets ii. Capital market iii. Derivative market iv. Offshore market 1.2 a) Intermediation function b) Operation of the payment system c) As a channel for transmission of monetary policy 1.3 Sources of fund: a) Deposits b) Insurance, provident and pension funds c) Capital, reserve and profit b) c) Uses of fund: a) Loans and advances Securities Deposits with other financial institutions

1.3

FLOW OF FUNDS AND DIRECTION OF CREDITS

FLOW OF FUNDS IN AN ECONOMY The evolution of a financial system can be broadly categorized into four basic s tages. 1. Barter trade to monetary system The first stage is when the economy moves from a barter trade system into a monetary system, whereby commodity money was used as the basic transmission uni t. Under this system, tokens, often made of precious metals served as a standard unit of account and measures of value to facilitate trade. 2. Saving and borrowing practices The second stage came when the practice of borrowing began. Funds accumulated b y wealthy persons were loaned to other individuals or companies who were willin g to pay for these funds for a fee or interest. This is where those economic uni ts who are in need of funds deficit units came to terms with those who have excess funds to be lent out or called surplus units. At this stage, however, there are s ome problems such as the difference in amount, maturity and the element of risks . 3. Establishment of financial intermediaries The third stage came following the establishment of financial intermediarie s to overcome the problems of primary debt in the direct borrowing-lending proce ss. During this stage, financial intermediaries mobilize from the surplus units and reduce their risk of default by issuing relatively risk-free liabilities. At the same time, through their specialized knowledge of the credit market, they w ere able to supply funds to deficit units in the amount and terms that these uni ts were willing to pay to meet its financing needs. The liabilities of these fin ancial intermediaries are known as secondary or indirect debt. 4. Varied financial instruments The final stage is when a complete set of financial intermediaries were esta blished to form a financial system which provide a variety of financial instrume nts as saving media for the surplus units, as well as a varied range of credit a nd investment facilities to meet the financing requirements of the deficit units . In of Malaysia, the country can be considered to have arrived at the final sta ge of the evolution process in establishing a complete monetary system. Major sectors of the economy To illustrate how fund flows in an economy with a developed financial system, it can be divided into five major institutional sectors. These sectors are: a) households b) enterprises c) government d) financial institutions e) external sectors

Each sector has different sources and uses of funds from the other sectors and b ehaves relatively homogeneous as a group. The household sector, as a group is usually the major net surplus unit in an eco nomy since they save a large proportion of their income and invest their savings in the form of real and financial assets. However, not all households are surpl us units as a significant proportion of the funds mobilized by the financial int ermediaries are channeled back to household in the form of consumer credits and housing loans. The private enterprises and the government sectors are usually the deficit units since they are the sectors primarily involved in the investment process in an e conomy. These sectors mobilize resources mainly through the financial system in the form of loans equity capital, bills and long-term securities. The financial system basically serves to assist in the allocation of scarce reso urces in an economy from the surplus units to the deficit units. To do this, an efficient recycling mechanism is essential in order that scarce resources would be used to their optimum for the development of the nation. Financial intermediaries primarily operate in two markets. First is the saving m arkets where they operate as borrowers while meeting the demand for financial as sets by surplus units. To fulfill this function, financial institutions have int roduced various savings and investment instruments to attract funds from the sur plus units. The other one is the credit market where financial intermediaries su pply the financial resources required by the deficit units. Here, again, they of fer various financial instruments as a conduit to supply funds to the deficit un its. Under the present situation, financial intermediaries operate in various markets such as the money and foreign exchange markets, the capital markets and the fin ancial futures and option markets.

Table 1.3 The flow of funds in an economy

DIRECTION OF CREDITS The financial system extended credit to the non-financial private sector in the form of loans and advances, as well as through the holding of corporate securiti es. Figure 1.2 below provides a graphic illustration of the change in the direct ion of credit to the non-financial private sector over the period. Sector 1988 1998 Investment in corporate securities 11.5% 24.0% Manufacturing 15.6% 9.7% Construction 18.8% 15.6% Housing 13.7% 11.1% Consumption credit 4.1% 8.5% Purchase of shares 1.1% 4.8% Others 35.3% 26.3% Table 1.4 Direction of credit. (% of total credit outstanding) (Source: The Central Bank and the Financial System in Malaysia A Decade of Change; BNM 1999) Figure 1.2: Direction of credit (1988)

Figure 1.3: Direction of credit (1998) 1.4 LATEST MONETARY POLICIES The Malaysian economy was fundamentally strong prior to the start of the crisis . In the first two quarters of 1997, real GDP continued to grow at about 8%. Th e government continued to record fiscal surpluses and, very importantly, the lev el of external debt was low at 43.2% of GNP. At the end of 1997, the fundamental s of the economy were strengthened further. The economic growth was achieved re sulting in a lower inflation rate and an improved balance of payments position. In the banking sector, the structural reforms undertaken since the mid-1980s str engthened the banking system. Given the strong macroeconomic and institutional fundamentals at the outset of t he crisis, Malaysia had greater flexibility in responding to the crisis. While t here were structural imbalances present such as the current account deficit, ass et inflation and high credit growth, policies were already in place to address t hese weaknesses and positive results began to emerge. Despite strong fundamentals, the East Asian financial crisis affected Malaysian economy in numerous ways. In addition to instability of financial markets, the crisis affected the real sector and weakened the financial sector. Towards the e nd of 1997, the real GDP increased by 7.5% (10% in 1996). However, in 1998, the

real GDP declined by 7.5%. That was the first negative growth registered since 1985 and the trough was reached in the third quarter of 1998. The crisis affecte d all the broad sectors in Malaysian economy including the financial, real and external sectors. However, due to the stronger fundamentals and affirmative acti on to eradicate poverty, the social consequences from the crisis was less severe on Malaysia. The impact of the crisis on Malaysian economy was discussed as below: Depreciation of Ringgit The crisis was felt in the KL foreign exchange and stock markets. Between end of June 1997 and end of December 1998, ringgit was depreciated by 33.6% against th e United States Dollar. It was further depreciated to a historic low of RM4.88 a gainst the US Dollar on 7th January 1998, but strengthened thereafter. From Febr uary to June 1998, the value of ringgit was relatively stable between US$1= RM3 .84-3.98. From June to August 1998, the downward pressure on ringgit was intens ified following the depreciation of the Japanese Yen, the contraction in the dom estic economy and increased speculative activity. The immediate impact of the ringgit depreciation was on the stock market , with the Kuala Lumpur Stock Exchange Composite Index (KLSE CI) declining about 144.8% in the second half 1997. As the contagion spread in the region, investor s confidence was further eroded, the reversal of short-term capital flows caused the ringgit to be depreciated further by as much as 20% on 7th January 1998 and the KLSE CI to decline to as low as 286 points on 1st September 1998.

State of the banking system The sharp depreciation of ringgit combined with the fall in share prices had a material adverse effects on earnings and overall performance of the banking sect or. The decline in the property and stock markets, the debt-servicing capacity o f borrowers was also affected by the economic contraction, resulting in deterior ation in the asset quality of the portfolio of the banking institutions. The rel uctance of the banking institutions to lend, combined with higher interest rate led to severe difficulties for individuals and businesses, including viable busi nesses in productive economic activities, to obtain financing. These development caused loan growth (including loans sold to Danaharta) to slow down from of 26 .5% at the end of 1997 to 1.3% at the end of 1998. Inflation The price pressures arose from the depreciation of ringgit became apparent towa rds the end of 1997. Inflation, in terms of CPI, peaked at 6.2% on an annual bas is in June 1998, and moderated thereafter. In 1998 alone, the CPI rose by 5.3%, the highest increase since 1982. The PPI also increased by 10.7% in 1998 (2.7% i n 1997). The rather mild inflation, despite the severe depreciation, was due mainl y to the contraction of domestic demand.

Policy response to the crisis. Initial Policy Response Initially, Malaysia did follow some of the standard IMF prescriptions adopted by other crisis countries, but subsequently choose a different route. While the po licy direction was changed early in the crisis, the ultimate objective of ensuri ng growth with the price stability remained unchanged. The selective exchange co ntrol measures were a necessary part of the efforts to stabilize domestic finan cial markets to ensure that the prospects for an economic recovery would not be jeopardized by external developments and contagion. High interest rate to contain speculation against the ringgit was adopted only f or a brief period. When it proved ineffective, interest rate were restored to pr e-crisis levels soon after, and were maintained till September 1997. Thereafter, interest rates were adjusted to reflect higher rates of inflation to ensure a p ositive real rate of return to savers. As higher interest rates were considered detrimental to the real sector, a credi t plan was introduced in September 1997 to moderate loan growth. The target loan growth rate was set as 25% by the end 1997 (from 29% at end September 1997), a 20% by the end of the first quarter of 1998 and 15% by the end of 1998. In addi tion, more stringent guidelines were imposed on hire purchase loans for non-comm ercial passenger vehicles. With respect to fiscal policy, the government reduced its expenditure and deferr ed implementation of selected infrastructure projects. The government, however, ensured that budget allocations with respect to health, education and the provis ion of other basic amenities were maintained. In early 1998, the IMF advised aga inst Malaysias plans to reverse fiscal policy to a deficit position to arrest eme rging signs of economic contraction. However, in April may 1998, when it was cle ar that the economy was contracting, Malaysia unilaterally allocated additional fiscal expenditures amounting to RM3 billion. In the financial sector, prudential regulations of the financial sector were adj usted further to be consistent with international standards. This included recla ssification of loans as non-performing which had been in arrears for 3 months (i nstead of 6 month previously), increasing the rate for general provisioning and requiring greater financial disclosure by banking institutions. The need for a change in policy direction The combination of tight monetary policy and fiscal restraint adopted in an envi ronment of weakening external demand caused aggregate demand to fall more sharpl y than anticipated. Then, the Malaysian Government adopted a more comprehensive and forward-looking policy approach. Policies were formulated taking into accoun t the likely developments and the associated risks. The approach was a pragmatic one to adjust the policy direction to the changing economic circumstances. Economic Recovery Plan Mid 1998 Beginning mid-1998, the policy focus shifted towards reviving the economy. In vi ew of this objective, the government eased its monetary and fiscal policies. Ami dst the deteriorating economic conditions, the National Economic Action Council (NEAC) was established on 7 January 1998 to make concrete recommendations to the government to arrest the worsening economic situation and revitalize the econom y. On 23 July 1998, the NEAC launched the National Economic Recovery Plan (NERP) to provide a comprehensive framework for economic recovery and to counter the n egative impact of the ringgit depreciation and the decline of the stock market. The NERP had six objectives, which included the short-term focus of stabilizing

the ringgit; restoring market confidence; and maintaining financial market stabi lity. These were complemented with structural reform objectives of strengthening economic fundamentals; continuing the socio-economic agenda; and restoring adve rsely affected sectors. Since early August 1998, monetary policy has become accommodative by reducing in terest rates and the SRR to reinforce expansionary fiscal policy and revive the economy. The 3-month intervention rate of BNM was reduced in three successive st eps, from 11% to 9.5% during the month of August. The SRR was reduced from 8% to 6 % on 1 September, when the selective exchange controls were imposed and furth er to 4% on 16 September in order to ensure adequate liquidity in the banking sy stem and to reduce their cost of funds. The importance of the efficient functioning of the intermediation role of the ba nking institutions came to the forefront during the crisis period. In an environ ment of uncertainty, banking institutions had become excessively cautious in the ir lending decisions, causing a sharp slowdown in credit. To avoid a credit crun ch situation, banking institutions with sufficient capacity were encouraged to a chieve a minimum loan growth rate of 8% for 1998. Pre-emptive measures were also introduced to strengthen the resilience of the fi nancial sector to avoid systemic risks and to ensure the continued efficient fun ctioning of the banking sector and promote market confidence in the face of dete riorating economic conditions. The measures were multi-pronged - aimed at stren gthening all aspects of the financial system. The measures included the consolid ation of the finance companies, the establishment of Danaharta, to purchase NPLs from banking institutions and manage these NPLs in order to maximize their reco very value; Danmodal, to facilitate the recapitalisation of banking institutions ; and the Corporate Debt Restructuring Committee (CDRC), a platform for both th e borrowers and the creditors to work out feasible debt restructuring schemes wi thout having to resort to legal proceedings. Selective Exchange Control Measures The selective exchange control measures were designed to achieve specific object ives. The controls were aimed specifically at eliminating access to ringgit by s peculators by reducing the offshore market in ringgit and limiting the supply of ringgit to speculators. In addition, the measures were also aimed at stabilizin g short-term capital flows. They were carefully designed to have minimal impact on economic activities. Thus, rules that governed trade transactions and foreign direct investment were left unchanged. Current account convertibility continued to be maintained. The only requirement was for trade settlements to be carried out in foreign currencies. These measures were essentially aimed at curbing the internationalization of the ringgit. As such, the exchange controls affect only short-term flows. Medium and long-term flows of foreign funds into the country c ontinue to be unaffected by the controls. The main selective exchange control measures were: control the transfer of funds in the external accounts to immobilize trading of ringgit offshore; control on ringgit loans to non-residents; imposition of the 12-month holding rule on the repatriation of funds in external accounts (replaced by repatriation levy on portfolio funds on 15 February 1999 which was subsequently liberalized further on 21 September 1999); limiting the amount of ringgit that could be imported or exported and the amount of foreign currency that could be exported. 1.5 ACTS THAT REGULATE FINANCIAL INSTITUTION

 The Banking and Financial Institutions Act 1989 (BAFIA) A major event which took place in 1989 was the introduction of the Banking and F inancial Institutions Act 1989 (BAFIA) to replace the Banking Act 1973 and Finan ce Companies Act 1969. The introduction of BAFIA was intended to provide an int egrated supervision of the Malaysian financial system and to modernize and strea mline the laws related to banking and banking institutions. Rationale for BAFIA The growing competition in the banking system had resulted in the blurring of li nes of business between the three traditional groups of banking institutions und er the Central Bank supervision, namely, commercial banks, merchant banks and fi nance companies. This had let to the extent that the methodology of supervision of these institutions had increasingly converged although the legislative basis for supervision was legally separated under the repealed Banking Act 1973 and re pealed Finance Companies Act 1969. BAFIA placed all banking institutions supervised by the Central Bank, including discount houses and money and foreign exchange brokers which were previously sup ervised on an administrative basis, under one supervisory and regulatory scheme. BAFIA was built on the strength of the regulatory regime in the two repealed a cts, while the prudential and structural regulatory features essential for ensur ing the stability of the banking system have not been changed under the BAFIA. The Institutions under BAFIA a) Licensed institutions Comprising commercial banks, merchant banks, finance companies, discount houses , money brokers and foreign exchange brokers. b) Scheduled institutions Comprising the major non-bank sources of credit and finance and representative o ffices of foreign banks or foreign institutions which carry out the business or activities similar to the scheduled institutions. c) Non-scheduled institutions Comprising all other statutory bodies and institutions involved in the provision of finance and credit. The Offshore Banking Act 1990 The Offshore Banking Act 1990 (OBA) governs the activities of offshore banking a nd offshore investment banking. Bank and financial institutions intending to op erate as an offshore investment bank in Labuan are required to seek a license fr om the Minister of Finance through Labuan Offshore Financial Services Authority (LOFSA). In the amendments to OBA in 1996, major changes were made, among others, b y expanding the definition of offshore banking business to include a wide range of financial services that could be undertaken by offshore banks instead of only providing credit facilities and accepting deposits. The Islamic Banking Act 1983 An act which came into effect on April 7th 1983, to provide for the licen sing and regulation of Islamic banking business. The act inter alia has provisi ons on the financial requirements and duties of an Islamic Bank, ownership, cont rol and management of Islamic banks, restriction of its business, powers of supe rvision and control over Islamic bank and other general provision such as penalt ies etc. 1.6 i. ROLE AND PURPOSE OF REGULATORY BODIES Bank Negara Malaysia

Bank Negara Malaysia (BNM) is a regulatory body to have primary oversight of the monetary and banking system in Malaysia. To enable BNM to meet its objectives, it is vested with comprehensive legal powers under various Acts and Ordinances t

o regulate and supervise the financial system. BNM was also as agent of the gove rnment on exchange control matters. Furthermore, effective 1 May 1988, BNM was a lso responsible for the supervision, regulation and development of the insurance industry as part of the financial system. ii. Security Commission To streamline the regulatory structure of the capital markets, the Security Comm ission (SC) was established under the Securities Commission Act 1993, as a selffunding statutory body with investigate and enforcement powers. The mission is t o promote and maintain fair, efficient, secure and transparent securities and fu tures markets and to facilitate the orderly development of an innovative and com petitive capital market. The SCs many regulatory functions include: Supervising exchanges, clearing houses and central depositors; Registering authority for prospectuses of corporations other than unlisted recre ational clubs; Approving authority for corporate bond issues; Regulating all matters relating to securities and futures contracts; Regulating the take-over and mergers of companies; Regulating all matters relating to unit trust schemes; Licensing and supervising all licensed persons; Encouraging self-regulation; and Ensuring proper conduct of market institutions and licensed persons.

Activity 1B

TEST YOUR UNDERSTANDING BEFORE YOU CONTINUE TO THE NEXT INPUT! 1.4 List down five major sectors in the economic fund flow.

1.5 Name three special mechanisms which are established to overcome the seriou s increas NPLs banking industry. 1.6 Name the regulatory bodies in Malaysian financial system.

Feedback To Activity 1B

1.4 i) Households ii) Enterprises iii) Government iv) Financial institutions v) External sectors 1.5 Danaharta, Danamodal and Corporate Debt Re-structuring Committee (CDRC) 1.6 Bank Negara Malaysia and Security Commission

1.7

CHARACTERISTICS, ROLES AND OBJECTIVES OF IOFC

The Characteristics of an IOFC An offshore is basically a small territory or jurisdiction that imposes low or n o taxes on income, profit, dividend and interest earned or derived from the offs hore business activities or transactions carried out by offshore multinational c orporation in or from those jurisdictions. Generally also, it does not have any exchange control or limitation or transboundary movement of funds into and out o f the jurisdiction by the offshore company, no stamp death, inheritance or estat e duties and no value added tax. An IOFC maintains a high degree of secrecy thro ugh limitation on public inspection of company files, prohibition from disclosur e of the shareholding or beneficial ownership and management of the business, fi nancial or other affairs of the company other than in compliance with the law. The roles and objectives of IOFC In summary, the objectives of establishing Labuan IOFC are as follows: a) to enhance the attractiveness of Malaysia as an investment centre. b) to supplement the onshore financial system centre in Kuala Lumpur by tap ping the growing demand for tailored financial and related services. c) to strengthen the contribution of broad financial sector to the progres s of diversified economic growth. d) To form part of the broad national strategy to spread out and diversify the growth opportunities of the nation, focusing attention on the further develo pment of East Malaysia in terms of industrial and services (including tourism) d evelopment. 1.8 FACTORS THAT CONTRIBUTE TO THE SUCCESSFUL OPERATION OF IOFC There are some factors that contribute to the success of the existing IOFC: a) Political stability in the country which is a crucial factor in the inve stment decisions of the potential players. b) Stable currency with minimum or no exchange control. c) Banking secrecy and confidentiality coupled with minimum rules and regul ations. d) A competitive tax regime. The tax rate imposed on offshore companies is among the lowest in the world. e) Lower operating costs compared to other financial centres in the region. f) Good infrastructural support facilities such as excellent communications and transportation system with other financial centres. g) Professionally qualified and experienced workforce. 1.9 FINANCIAL SERVICES WHICH IS OFFERED BY IOFC AND INCENTIVES GIVEN TO THE PARTICIPANTS Some of FC are: a) b) c) Financial services offered in Labuan IOFC the international business activities that can be conducted in Labuan IO offshore banking operations offshore insurance and offshore insurance-related businesses corporate funding

d) e) f)

investments and trust management offshore investment holding companies professional services and other related services.

Incentives to operate in Labuan IOFC Some of the incentives offered to financial institutions to attract them to oper ate in Labuan IOFC are: a) Low or no taxes on income, profit, dividend and interest earned from off shore business activities or transactions carried out by the offshore multinatio nal corporation in or from the territory. b) No limitation or exchange control on the movement of funds in or out of the territory (other than the standard exchange control requirements on resident and nonresident institutions). c) No levy stamp, inheritance, death or estate duties and no value added ta x. d) Strict rules on confidentiality in the territory or accounts in the terr itorys banks. 1.10 CHALLENGES OF THE FINANCIAL SECTOR IN GLOBAL ECONOMY The rapid intensification of globalization in recent years has significa ntly affected the structure and operations of financial institutions all over th e world, including Malaysia. Globalisation is rapidly and irreversibly changing the way business and policy are conducted. For instance, the global trend toward s liberalization in the financial system has led to the blurring of traditional demarcation lines separating the activities of the different groups of financial institutions and removed artificial barriers to competition. As a result, the a rray of activities that can be undertaken by different groups of financial insti tutions is converging. Technological advances in telecommunications, information processing and computing have been a key factor in integrating financial markets across the glo be, and in enabling the design of innovative and complex financial instruments t hat have helped to improve risk management and shifted risks to those who are be tter able to manage them. Consequently, economic agents have become willing to a ssume greater risk, while short-term capital funds have flowed rapidly in large amounts from developed economies into emerging economies since the late 1980s. The measures that have been undertaken so far would serve as the foundat ion to further enhance the capability and capacity of the domestic financial sys tem, and to achieve the agenda for the financial system, as follows: To create strong, efficient, competitive and resilient banking system that would be better able to withstand future shocks, thereby, minimizing the adverse impl ications on macroeconomic stability. To accelerate implementation of measures to broaden and deepen financial markets and strengthen the financial infrastructure. In particular, efforts will be int ensified to increase the proportion of non-bank financing in the economy and div ersify risks away from the banking system. In this regard, the further developme nt of the bond market and securitization would be accelerated. To inculcate strong risk management skills in order to ensure that there is no e xcessive risk taking that could result in adverse implications, given the increa sing volatility of the financial environment. To promote dynamism in developing new products and management systems.

Activity 1C

TEST YOUR UNDERSTANDING BEFORE YOU CONTINUE TO THE NEXT INPUT! 1.7 What are the main objectives of establishing International Offshore Finan cial Centre (IOFC)? 1.8 omy? What are the challenges faced by the financial sectors in global econ

Feedback To Activity 1C

1.7 To complement Kuala Lumpur as a regional financial centre, strengthen t he contributions of the financial services sector to the gross national product of Malaysia and promote the economic development of Labuan and its vicinity.

1.8 i) Liberalization in the financial system ii) Technological advances in telecommunications, information processing and computing.

KEY FACTS 1. a) i.i i.ii b) i. ii. iii. iv. Briefly the structure of the financial system is as follow: Financial institutions Banking system Non-bank financial intermediaries Financial markets Money and foreign exchange markets Capital market Derivative market Offshore market

2. The roles of financial institutions and financial intermediaries in the countrys development: a) Intermediation function b) Operation of the payment system c) As a channel for transmission of monetary policy 3. a) b) c) d) The main assets of the financial system: Commercial banks Provident and pension funds Bank Negara Malaysia Finance companies

4. Financial intermediaries primarily operate in two markets. First in the saving market where they operate as borrowers while meeting the demand for finan cial assets by surplus units. The other one is the credit market where financial intermediaries supply the financial resources required by the deficit units. 5. The main objectives of establishing International Offshore Financial Cen

ter (IOFC) are to complement Kuala Lumpur as a regional financial center, streng then the contributions of the financial services sector to the gross national pr oduct of Malaysia and promote the economic development of Labuan and its vicinit y.

SELF-ASSESSMENT 1

You are approaching success. Try all the questions in this self-assessment secti on and check your answers with those given in the Feedback on Self-Assessment 1 given on the next page. If you face any problems, discuss it with your lecturer . Good luck. 1. The Malaysian financial system can be broadly divided into banking syste m and non-bank financial intermediaries. Distinguish the groups of institutions that fall into the two categories. 2. In an economy, the financial system acts as the conduit for the flow of funds, channeling savings of the economy for productive investment. The more efficient the system of financial intermediation, the more effective it would be in mobilizing previously idle resources for development in those areas that need these funds the most. Describe how funds flow an economy. Identify the units that are considered havin g surplus funds and those in need of funds.

Feedback To Self-Assessment 1

1. a) Financial Institutions The banking system which is the major component of the financial sector consists of: Bank Negara Malaysia Commercial banks (include Bank Islam Malaysia Berhad and Bank Muamalat M alaysia Berhad) Finance companies Merchant banks Discount houses Foreign banks representative offices They are regulated and supervised by the central bank. b) Non-bank financial intermediaries The non-bank financial intermediaries are mainly supervised by other government agencies. These institutions can be divided into five major groups consisting of: i. Provident and pension funds ii. Insurance companies iii. Development financial institutions iv. Saving institutions v. Other non-bank financial intermediaries comprising Unit trusts, Pilgrims Fund board, Housing Credit Institutions, Cagamas Berhad, Credit Guarantee Corpo ration, Leasing Companies, Factoring Companies and Venture Capital Companies. 2. The flow of fund is presented in graphical form table below to provide i nformation on how savings are mobilized through the organized financial system i ncluding banking institutions. It also illustrate how these funds are utilized.

The units that are considered having surplus funds and those in need of funds: Household: usually the major net surplus unit Enterprises: usually the deficit units Government: usually the deficit units External sector: usually the deficit units